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Could Restrictions on Payday Lending Hurt Consumers? · PDF file Of course, a payday loan provides cash. Most credit card fees on cash advances, if considered short-term loans, are

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  • Could Restrictions on Payday Lending Hurt Consumers?

    By Kelly D. Edmiston

    The payday loan, or more generally, the deferred deposit loan, is among the most contentious forms of credit. It typically signi-fies a small-dollar, short-term, unsecured loan to a high-risk borrower, often resulting in an effective annual percentage rate of 390 percent—a rate well in excess of usury limits set by many states.

    Consumer advocates argue that payday loans take advantage of vul- nerable, uninformed borrowers and often create “debt spirals.” Debt spirals arise from repeated payday borrowing, using new loans to pay off old ones, and often paying many times the original loan amount in interest. In the wake of the 2008 financial crisis, many policymakers are considering strengthening consumer protections on payday lending.

    A substantial volume of literature has examined the dangers of pay- day lending, yet few studies have focused on any unintended conse- quences of restricting such lending. Thus, the question arises: Could restrictions on payday lending have adverse effects?

    This article examines payday lending and provides new empirical evidence on how restrictions could affect consumers. The first section discusses why many states restrict the practice of payday lending and

    Kelly D. Edmiston is a senior economist at the Federal Reserve Bank of Kansas City. This article is on the bank’s website at



    describes the pattern of restrictions. The second section explores ways in which restrictions might adversely affect consumers. The third sec- tion reviews the limited existing evidence on such effects and provides new evidence.

    The analysis shows that restrictions could deny some consumers access to credit, limit their ability to maintain formal credit standing, or force them to seek more costly credit alternatives. Thus, any policy decisions to restrict payday lending should weigh these potential costs against the potential benefits.


    Payday lending came under fire almost as soon as it surfaced, and consumer advocates have kept pressure on lenders and policymakers ever since. Chief among the concerns are the high cost of payday loans, the tendency for payday loans to contribute to consumer debt spirals, and the targeting of payday lending to financially vulnerable popula- tions. These concerns often justify calls for additional regulation of payday lending.

    The costs of payday borrowing

    Consumer advocates feel that payday loans are a menace to con- sumers for a number of reasons, but chief among these is their high cost. Most states have established legal limits on the rate of interest that can be charged on a loan, usually 6 to 12 percent (Glaeser and Scheink- man). In many cases, however, lenders are not subject to these laws. For example, the Depository Institutions Deregulation and Monetary Control Act of 1980 eliminated usury limits for most loans made by banks. Some payday lenders have partnered with banks to take advan- tage of looser usury laws (Chin). Other lenders or types of loans are subject to their own specific laws.

    While payday lenders often charge fees rather than interest payments, in effect these charges are interest. Comparing the terms of varying types of loans requires computing an effective, or implied, annual interest rate. For payday loans, this computation is straightfor- ward. A typical payday loan charges $15 per $100 borrowed. If the term of the loan is two weeks, then the effective annual interest rate is 390 percent. By comparison, in 2010 the average annual interest


    rate (APR) on credit cards, the traditional source for rapid short-term loans, was 14.7 percent (Simon). Thus, the fee on a typical payday loan is more than 25 times greater than the interest on a typical credit card.

    Of course, a payday loan provides cash. Most credit card fees on cash advances, if considered short-term loans, are costly as well. The fee for cash advances on many credit cards has recently climbed to 4 or 5 percent (Blumenthal). In addition, higher interest rates, which average 25 percent, generally apply to cash advances (Blumenthal). Thus, on a two-week loan, the effective annual interest rate would average from 129 to 155 percent. In addition, cash advances are typically not subject to the interest grace period associated with purchases.

    Presumably, a potential payday loan borrower would use a credit card if available. A 2009 study found that most payday borrowers with credit cards have “substantial credit card liquidity.” Yet borrowers often choose not to use their credit card (Agarwal and others). Such financial behavior could result from a lack of information, at least for some bor- rowers. While the typical APR on a payday loan is 390 percent, about one-third of the respondents to a 2007 survey of payday loan customers reported an implausibly low APR on their most recent payday loan of less than 30 percent, and half reported an APR of less than 200 percent (Elliehausen). About 95 percent of the respondents gave an accurate report of the finance fee in dollar terms. Thus, many borrowers appear to have a problem translating the fee into an APR.1

    Other, more informed, consumers may choose a payday loan over available traditional credit for sensible reasons. Such behavior is similar to that of consumers who use credit cards to make purchases when they have available low-earning liquid assets. For example, many households hold cash in savings or money market accounts that currently earn less than 1 percent. Yet they often choose to roll over large amounts of cred- it card debt from month to month, paying an average interest rate of about 15 percent. The pecuniary losses associated with this pattern of behavior can be quite large. Some researchers argue that households rec- ognize a need to have money readily available when using a credit card is not an option—for example, when making rent payments (Telyukova and Wright). Similar logic may explain why some borrowers resort to payday loans even if they have credit cards.


    Another potential explanation for this credit puzzle is that payday lenders are misleading consumers. There is limited evidence for this ex- planation. The Center for Responsible Lending suggested in 2001 that much of the misinformation about payday loan interest rates can be attributed to intentional misrepresentation on the part of lenders. The report quotes a payday lender’s business plan:2

    Remember, in your response to clients’ questions regarding your fees, [say] “We charge $15 per $100 advanced.” Sounds like 15%, but in reality since it is an 8 day loan, the true annual percentage rate is 805%!

    Further, an evaluation of payday lending in Colorado revealed that most promotional finance fees from payday lenders are provided for the first loan only, at least in that state (Chessin). Given that payday customers often have trouble repaying loans without additional borrowing, typically from the same lender, promoting fees in this way could lead borrowers into a series of renewals that rapidly increase the cost of the loan.

    A reasonable argument could be made that payday lenders take advantage of customers who have few other options—and perhaps no options with favorable terms. Evaluating this argument rests largely on examining the profitability of payday lenders. If payday lenders’ costs justify their high prices, then the argument may not be sound.

    Payday lenders typically offer two justifications for their high fees (Huckstep). First, their operating costs are especially high. For example, because an important attribute of payday lending for customers is conve- nience, payday lenders must maintain a high density of stores and remain open beyond normal business hours. Second, the incidence of default on payday loans is high. A 2005 FDIC study reported that the mean ratio of loan losses to total revenue for the two large payday lenders studied was 15.1 percent (Flannery and Samolyk). Overall, this study and Huckstep’s research suggest that large fees on payday loans may be warranted. Fur- ther, evidence has shown that firm-level returns of payday lenders differ little from typical financial firms (Skiba and Tobacman 2007a). Thus, while some payday lenders may take advantage of borrowers in some ways, payday lenders in general are not gouging borrowers.3


    Debt spirals

    While profitability may not be excessive among payday lenders generally, data suggest that the bulk of lenders’ profits come from re- peat borrowers (Chin). The payday business model may therefore rest on activities that may not be in the best interest of most consumers.

    According to a recent report by the Center for Responsible Lend- ing, only 2 percent of payday loans are extended to nonrepeat bor- rowers (Parrish and King). More than three-quarters of payday loans are made to borrowers who have paid off another payday loan within the previous two weeks. The remainder consists of initial loans to re- peat borrowers and repeat loans that occur more than two weeks after the previous loan. Another study of 145,000 payday loan applications found that, on average, those approved for a payday loan subsequently applied for 8.8 additional payday loans (Skiba and Tobacman 2007b). Most states have limits on loan rollovers, which involve extending the due date of the

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